No doubt you've seen loads of advertisements for mutual funds that tell you how much money their funds made but then warn you that past performance is no guarantee of future results. Just because a fund is up 10% one year doesn't mean the managers will be able to repeat the feat the next.

In fact, quite often, top-performing mutual funds will underperform their benchmarks and their peers in the future.¹ According to a study by Baird, 85% of the top quartile of mutual fund managers underperformed their benchmark by one percentage point or more over any three-year period. And 50% underperformed by three percentage points.

But that's not necessarily the case when it comes to Perpetual Dividend Raisers. Although the future rise or fall of the stock price may correlate to how it's done in the past, the dividend should be very closely related.

Chances are, a company that has raised its dividend for 25 years in a row is going to do it again in year 26. And again in year 27. And in year 28. . . .

As I explain in the next chapter, there are very solid reasons that managements pay and increase dividends to shareholders. To change the company's dividend program (i.e., not raising the dividend) after several decades represents a dramatic shift in policy that is not taken lightly.

In 2014, no companies fell off the Dividend Aristocrat Index. All 54 companies continued to raise their dividends.

The prior year, 2013, one company was removed from the list—Pitney Bowes (NYSE: PBI)—but not because it failed to raise its dividend. It actually boosted the dividend slightly in 2012. The problem was its market cap fell below the $3 billion minimum.

Since then, the company's market cap has risen back above $3 billion, but the troubled company cut its dividend in half in May of 2013.

In 2012, only one company fell off the list. Between 2008 and 2012, the average number of companies deleted from the index each year was five. And remember, 2008 and 2009 were the years of the Great Recession. Not including those two very difficult years, we usually see only two or three stocks fall off the list—far less than 10% of the companies in the index.

So, in normal years, you have better than a 90% chance of seeing your Aristocrat company continue to raise dividends. And in years of financial collapse, roughly 80% of the companies continued to increase their dividends.

When you invest in Perpetual Dividend Raisers, you're banking on the ever-increasing income that they spin off or the tremendous wealth-building opportunity that compounding the reinvested dividend provides.

Chances are, you don't want to have to read earnings reports every quarter, wondering what the company's prospects are and whether it's generating enough cash to boost the dividend this year.

With Perpetual Dividend Raisers, you usually don't have to. The companies have proved after 15, 30, or even 50 years that they can deliver what their shareholders want, year after year, decade after decade.

That's what makes Perpetual Dividend Raisers so appealing. They are as hassle-free as you'll find in the stock market.

Now, that doesn't mean you should ignore your stocks. The portfolio we'll design in this book is meant for at least a 10-year holding period. You should still check in with each company from time to time and make sure the dividend is being paid, the dividend is raised annually, and no crisis is jeopardizing the dividend or the company's long-term health and prospects.

Even a solid, well-run company can occasionally step on a land mine, which changes its prospects and makes the reason you invested in it no longer valid.

However, if you can learn not to get affected by every little hiccup in the company's business, the way analysts freak out over often-insignificant line items, you'll be able to hang on to your stocks more easily, allowing time and compounding dividends to work for you.

If a company's executives are managing a business for the long-term benefit of its owners (shareholders), it really doesn't matter if they miss earnings estimates by a few cents per share in any given quarter. In fact, if the market overreacts, that's positive for investors who are reinvesting dividends because they'll be able to do so at lower prices.

Certainly be mindful of your stocks' businesses and long-term prospects, but don't make buy-or-sell decisions based on any one data point or piece of news.

As I show you in Chapter 5, one of the attractive features of investing in these kinds of stocks is how easy it is and how little time you need to devote to maintaining your portfolio. Don't get caught up in CNBC's hysterics or any other financial media's scary headlines that are designed to frighten you into hanging on their every word. And that's coming from someone who regularly appears on CNBC.

If you stay the course, for the most part, over the next 10 years, the portfolio you create of Perpetual Dividend Raisers will create an ever-increasing stream of income or build wealth—with very little work required from you.

Performance of Perpetual Dividend Raisers

It was never my thinking that made the big money for me. It was always my sitting.

—Jesse Livermore, legendary investor

Numerous studies show that companies that raise dividends have stocks that outperform those that don't.

According to Ned Davis Research, companies that raised or initiated dividends from 1972 to 2010 did significantly better than those that didn't. And the companies that did not pay a dividend or, heaven forbid, cut their dividend, weren't even in the same ballpark as the dividend payers and raisers.

After 38 years, the dividend cutters were worth only $82 after a $100 original investment, a compound annual growth rate of –0.52%. The nonpayers were worth a whopping total of $194, for a minuscule 1.76% annual return. Companies that paid a dividend but kept it flat were worth $1,610, or 7.59% annually. But the dividend raisers and initiators generated a compound annual growth rate of 9.84% and were worth $3,545. (See Figure 3.1.)

There's nothing wrong with 9.84% annually over 38 years. But a little later on, I show you how to generate at least 12% annual returns, which would turn that $100 into nearly $7,500 in the same period.

Historically, the S&P Dividend Aristocrats index has outperformed the S&P 500. Since inception in 1990, Aristocrats have returned 901% versus the S&P 500, which returned 469%.

Interestingly, the only period the Aristocrats underperformed the overall market was during the late 1990s, when the dot-com bubble inflated nearly everything. Stable, so-called boring dividend stocks were out of favor as investors rushed into anything that had risk.

It was a “new paradigm,” many experts said. “This time is different,” they declared. You'd be throwing your money away investing in traditional blue chip companies. How could you invest in Coca-Cola (NYSE: KO) when you have the opportunity to invest in a white-hot growth stock, like Pets.com?

You can see from Figure 3.2, as soon as the market reversed and investors recovered their sanity, Aristocrats significantly outperformed the S&P from thereon after.

Additionally, Dividend Aristocrats outperformed the S&P 500 with less risk. Over the past 10 years, the index's standard deviation—a measure of volatility—was 13.6% versus the S&P 500s 14.7%, indicating that the Aristocrats are less volatile (risky) than the general market.

And you can see in Figure 3.3, which was created by Alan Gula at Dividends and Income Daily, that for the past 40 years, stocks that cut or didn't pay dividends had a lower rate of return, while investors had to endure greater risk as measured by standard deviation. Dividend growers and initiators (declaring dividends for the first time) had the highest return and lowest risk.

Another way to measure performance is the Sharpe ratio. Without getting into the complicated math, the Sharpe ratio measures how much return you are getting for the amount of risk you are taking.

It's a way of comparing investment returns when risk is considered. The higher the number, the better the risk-adjusted return.

The S&P Dividend Aristocrats index also outperformed the S&P 500 when it came to the Sharpe ratio, meaning that the Aristocrats outperformed the market not only on an annualized basis (11.8% versus 7.0% over 10 years) but also on a risk-adjusted basis. And the Aristocrats did so with less risk, as measured by the standard deviation.

Table 3.1 compares the risk and reward versus risk of the S&P Dividend Aristocrats index and the S&P 500.

As you can see from Figure 3.4, both the returns and the Sharpe ratio were higher for Dividend Aristocrats than for the S&P 500. This is important because not only are you making more money, but on a risk-adjusted basis, you are also outperforming the market.

Based on the data, you could say that over 10 years, Aristocrats returned three times as much as the S&P 500, when risk is taken into account.

It makes sense when you think about it. The extra dividend yield lifts total return and attracts income-oriented investors, which can increase demand for the stock. Additionally, the decades-long track record of raising dividends represents stability.

So not only are you taking less risk, but you're also making more money. Usually in the market it's the other way around. Riskier investments tend to have bigger payoffs (and more of a chance of a loss).

Let's look at an example of one Aristocrat.

Chevron (NYSE: CVX) has raised its dividend every year for the past 27 years. Over the past 10 years, the dividend growth rate has averaged nearly 11% per year.

Including dividends, Chevron outperformed the S&P 500 154.9% versus 78.6% over the past decade. And while the yield on the stock as I write this is just 3.4%, the yield on the price you would have paid 10 years ago is 8.6%. (See Figure 3.5.)

So, if you had bought shares of Chevron 10 years ago, not only would your stock have doubled the return of the S&P 500, but you'd also be earning 8.6% on your money—a yield that today is associated with the junkiest of junk bonds rather than a blue chip company that has raised its dividend every year since The Bangles topped the charts with “Walk Like an Egyptian.”

What if you had started on this program of buying Perpetual Dividend Raisers years ago?

Although the Dividend Aristocrats index officially started only in 1990, if you'd bought shares of Procter & Gamble (NYSE: PG) in 1981, after it had increased its dividend for the twenty-fifth consecutive year, your shares would have outperformed the S&P 500 by 1.7 percentage points per year: 11.3% versus 9.6%.

Your yield would now be 102% on your original investment. That's not a typo. In 1981, Procter & Gamble shares were trading for about $2.51 per share, adjusted for splits. Today, those shares pay an annual dividend of $2.57.

So each year, you'd be getting a dividend that surpasses what you paid for your shares.

Here are some unbelievable numbers.

If, in 1981, if you'd bought $10,000 worth of Procter & Gamble, at the end of 2013, your investment would be worth $337,821, and you would have collected $108,940 in dividend checks. If you'd reinvested the dividend, you would be looking at a nest egg of about $811,840 and own over 9,700 shares, now generating $25,093 per year in dividends, all from a $10,000 investment. Your annual yield would now be two and a half times your original cost.

In 1981, I was entering high school. I shoveled snow in the winter and did other odd jobs to make money. I was a great saver, even back then. If I had taken my savings from many birthdays and long winter days with my snow shovel, purchased $1,000 worth of Procter & Gamble, and never touched it, today it would be worth $81,000. That would be a nice chunk of change for anyone to buy a car, pay down a mortgage, put toward the children's college educations, or just have extra funds to relieve some financial pressure.

Do you know a teenager who might thank you every time he or she thinks of you in 30 years because of a $1,000 investment today?

Let's look at another example.

Johnson & Johnson (NYSE: JNJ) pays a dividend of $1.68 per share, or a yield of 2.7%. Not bad by today's standards, but nothing too exciting.

The company has raised its dividend every year for 52 straight years—right around the time Mick Jagger and Keith Richards formed a little blues band called the Rolling Stones. It was also the year of the Cuban Missile Crisis. In 1987, after the company had established its 25-year track record, if you had bought 100 shares, you'd have paid $3,900.

In the middle of 2014, it would be worth over $219,000, and you would have collected $57,524 in dividends. If you'd reinvested those dividends, your total would be worth over $401,000, and you'd have more than 1,100 shares spinning off over $6,504 a year in income, or a 43% yield on your original cost.

That compares to the S&P 500, which would be worth $49,580 for a similar investment.

Interestingly, Johnson & Johnson and Procter & Gamble's returns were almost identical—14.3% annually when dividends were reinvested. So how did a P&G investor end up with $410,00 more than an investor in J&J?

Simple. Procter & Gamble's figures were calculated from 1981. Johnson & Johnson's were from 1987. As you'll soon see in several examples, the longer you hold a stock and reinvest the dividends, the more the numbers jump.

Compounding takes a while to get started, but once it does, it's like a runaway train going downhill, picking up momentum each year. The longer you can hold on to a stock, the greater the returns should be.

These are two examples of Perpetual Dividend Raisers that grow their dividends at roughly 10% or more per year. Many have lower growth rates but have nevertheless increased their dividends every year for 30, 40, or 50 years.

The key to obtaining the incredible results shown in the two examples is to find companies that not only have track records of growing dividends every year but also raise dividends at a large enough rate so that they keep ahead of inflation and become wealth builders.

How Do Bonds Compare?

Income investors like bonds because of their steady income and the reliability that investors can get their principal back when the bonds mature.

Whether we're talking about treasury, municipal, or corporate bonds, if you buy a bond, there's a very good chance you will get your money back.

Between 1925 and 2005, investment-grade bonds paid back bondholders 99.7% of the time. The default rate on higher-yielding junk bonds was 6%. So historically, junk bond investors have a 94% chance of getting their money back (although during the peak of the Great Recession, default rates in junk bonds climbed to 13%).

As I showed you earlier, during 10-year periods over the past 76 years, stocks were positive 91% of the time, about the same success ratio as junk bonds. But wait, junk bond investors got their money back only 94% of the time, while stock investors made money 91% of the time.

Furthermore, when you receive an interest payment from a bond, there is no way of making that income grow as the years go by. If you bought a 10-year corporate bond yielding 6%, you've agreed to lend the company money at a 6% interest rate.

If the company invents the next iPhone and profits explode higher, you'll receive 6%. If business is in the toilet, you'll receive 6%.

And when you get that check in the mail, the only way you're going to turn it into more money is if you find another place to invest it—an activity that's going to cost you time for sure and likely money.

If in 10 years you absolutely have to have those funds—you can't risk the money not being there—well then, you shouldn't be buying a junk bond. Invest it in a treasury.

But if you are able to take some risk, which you clearly can because you're buying a junk bond, you're better off with a stock that pays increasing dividends.

You can't reinvest bond interest. Of course, you can buy another bond if the interest payment is large enough or buy a stock or any other type of investment. But it will take time and cost you money to make another trade.

Conversely, if you're reinvesting the dividends from a stock, the dividend payment and reinvestment happen at the same time and for free with most brokers. It's one less thing that you have to think about, while your money compounds and grows.

Let's compare a junk bond and a Perpetual Dividend Raiser.

As I write this, Tesoro Corporation (NYSE: TSO) has bonds available with a 4.8% yield that mature in 10 years.

So over the next 10 years, an investor who buys $10,000 worth of bonds (10 bonds at $1,000 each) will receive annual payments totaling $480. At the end of 10 years, historically, he has a 94% chance of getting his $10,000 back and will have collected $4,800 in interest.

Also consider what happens when things go wrong. When bonds default, historically, bond investors receive only about 40% of their money back.³

A stock paying a 4% dividend yield whose dividend increases 10% per year would generate $6,374 in dividend payments over 10 years—more than you'd collect from the bond. And the bond price isn't going to be higher at maturity (unless you buy it below par).

The stock's price probably will be higher. Historically, it has a 91% success rate, slightly less than the bond as well. However, as I mentioned, stocks' average return is 7.84%, which includes down years.

After 10 years, a $10,000 investment in our example stock is worth $32,627 if dividends are reinvested. The bond plus interest is worth $14,800, less than half the amount the stock returned.

Historically, the stock has a greater chance of suffering a loss, but only by 3%. To compensate for the risk, stocks generate 92% in extra return. That's a more than acceptable reward-to-risk ratio.

And when things go wrong in the stock market—we're talking really wrong—stocks average a decline of 27% over 10 years. That's the historical 10-year rolling return of stocks when the market is negative over 10 years—periods associated only with the Great Depression and the Great Recession.

So in the past, you've had a 9% chance of losing 27% of your money over 10 years investing in stocks or a 6% chance of losing 40% of your money investing in high-yield bonds.

As the chapter title says, past performance does not guarantee future results. But we have decades' worth of data that shows that you have just a slightly higher chance of losing money in stocks than you do in high-yield bonds (and that's only when epic financial crises hit). And when you do lose money in stocks, you lose significantly less than you typically do with bonds.

With this information, it should be apparent that dividend stocks are a better investment than junk bonds. While the bonds may offer an attractive yield and the perception that the principal should be paid back at maturity, stocks, while a tad riskier, offer a much greater return and opportunity to generate wealth.

There will be instances when junk bonds are trading below par and offer investors the opportunity for capital gains along with the interest. However, to make the kind of gains necessary to compete with dividend stocks, the bond would have to be considered distressed, which would make it a very risky investment in most circumstances.

In those instances, it's not an apples-to-apples comparison. You'd be comparing a distressed bond versus (in all likelihood) a conservative stock—one that has a history of raising its dividend every single year. Companies in distress typically don't raise their dividends.

In fact, raising the dividend is usually a sign of financial health and confidence. Keep in mind that management would rather keep the money on the balance sheet or buy back shares, since compensation often is tied to earnings per share growth or the stock price.

When a management team raises the dividend, it signals that the company has plenty of cash to achieve its goals and expects there to be an abundance of cash in the future.

So a company with a track record of annual dividend raises that, once again, boosts its dividend is the opposite of a distressed bond.

Are You an Investor from Lake Wobegon?

Are you a good driver?

Are you a good parent? Son or daughter? Sibling? Spouse/Boyfriend/Girlfriend?

How do you rate in your, er, more intimate activities?

Most people think they're in fact pretty good in all of those categories—certainly above average. But statistics tell us that, in fact, most people cannot be above average.

And the majority of investors think they're above average in that skill, too, no matter what their brokerage statements tell them.

It reminds me of Garrison Keillor's Prairie Home Companion, which describes the fictional town of Lake Wobegon as a place where “all the women are strong, all the men are good-looking, and all of the children are above average.”

In fact, a psychological term, the Lake Wobegon effect, is a bias in which people overestimate their abilities. Investors are notorious for this trait.

It's unlikely that you (or anyone else) are a better-than-average investor. After all, even the pros stink out the joint most of the time.

According to Standard & Poor's, the majority of actively managed (not index) mutual funds underperform their benchmark index in just about every category.⁴ For the 12 months ending June 30, 2014, 60% of large-cap funds failed to return as much as the S&P 500. Midcaps were similar with 58% of funds underperforming. And 73% of small-cap funds did not do as well as their benchmarks.

The numbers are even worse when you expand the time horizon. Over three years ending in June 2014, a staggering 85% of large-cap mutual funds underperformed. 77% of midcap funds missed their benchmarks as did a mind-blowing 92% of small-cap funds.

But wait; for large-cap and midcap funds, it gets even worse over the five-year period: 87% and 88%, respectively, performed worse than their benchmarks. Small caps improved, so to speak, to 88% underperformance.

That means investors would have been better off investing in an index fund or exchange-traded fund (ETF) that tracks the index rather than trusting the manager to beat the market.

If your money is invested in actively managed mutual funds, you are paying a fund manager to, in all likelihood, make you less money than you could have simply buying an index fund or ETF.

And according to the Wall Street Journal, a study conducted by Dresdner Kleinwort showed that the forecasts of investment pros “were terrible.” But they found something fascinating:

. . . an almost perfect lag between forecasts and actual results.

Analysts would wait until stock prices rose and then forecast that stock prices were about to rise. After interest rates fell, analysts would forecast that interest rates were due to fall.

Analysts are terribly good at telling us what has just happened but of little use in telling us what is going to happen in the future.⁵

So, if these men and women who spend 10 hours a day or more in the markets can't succeed, isn't it highly unlikely that you'll be a better stock picker than they will?

The data shows that you won't—at least when it comes to timing.

According to the DALBAR Quantitative Analysis of Investor Behavior (QAIB) study, from 1990 to 2010, the S&P 500 gained an average of 9.14% per year while the average equity fund investor saw profits of only 3.83% per year—not even enough to keep up with inflation (see Figure 3.6).

What the study in Figure 3.6 shows us is that mutual fund investors are buying and selling at the wrong times. They buy when the markets get hot and sell when they fall, the exact opposite of what they should be doing.

Need more proof? See Figure 3.7.

Figure 3.7 shows the returns of 44 sectors and asset classes over the past 20 years, including the return of the average investor. Of the 44 categories, the average investor came in 41st, mostly because of buying at market highs and selling near market lows.

Still not convinced? Figure 3.8 shows how investors pulled lots of money out at the bottom and continued to remove money from the market, failing to take advantage of the strong rebound.

The remedy is to not be an active stock picker. To be successful, buy stocks that fit the criteria in this book, and leave them alone for 10 or 20 years. Trying to trade in and out of the market is a fool's game. Do you really know when Intel is going to miss earnings or when the market is about to tank? Let me answer that. You don't. Neither do I. And neither does that lady from Goldman Sachs or that guy from Fidelity.

Invest in great companies that raise their dividends every year. In several years you will have many times more money than if you try to trade the market or put your investment capital in an actively managed mutual fund.

One other thing to consider in light of the fact that I just shattered your self-image as the next Warren Buffett: When you invest in dividend-paying stocks, you're often more than halfway to matching the market's return.

The market historically appreciates an average of 7.84% per year. If you own a stock with a dividend yield of 3.8%, you're just about halfway there. You don't have to be Warren Buffett. In fact, you can be a lousy stock picker, one who invests in stocks that go up only half as much as the market, and you'll match the market's performance. And if you reinvest the dividends, you'll do even better.

If you invest in a stock with a 5% yield, you only need a gain of a few percentage points during the year to beat the market and the vast majority of professional investors, including the hedge fund manager with the $20 million New York penthouse apartment, $3,000 suits, and 120-foot yacht. You'll likely beat that guy.

But investors aren't the only ones who overestimate their abilities. Some CEOs think they can generate a better return for investors instead of giving some of that cash back. And, often, they're wrong.

DePaul University's Sanjay Deshmukh and Keith M. Howe and Navigant Consulting's Anand M. Goel created a model for determining whether a CEO is “overconfident” or “rational.”⁶ In their research, they concluded that “an overconfident CEO pays a lower level of dividends relative to a rational CEO.” Interestingly, overconfidence tends to be seen more often in companies with lower growth and lower cash flow, exactly the kind of companies where a CEO should not be overconfident.

Additionally, the market reacts with less enthusiasm to dividend announcements by companies headed by an overconfident CEO, suggesting perhaps that investors can sense the guy is a blowhard and are turned off by his management style.

Summary

• Companies that have a track record of increasing their dividend every year tend to continue raising it every year.
• Perpetual Dividend Raisers significantly outperform the market.
• The compounding of dividends is like a runaway train once it gets going and is the key to building wealth in the stock market.
• Reinvesting dividends protects you and allows you to profit in extended bear markets.
• You're not as good an investor (or driver) as you think you are. Neither are the overwhelming majority of overpaid mutual fund and hedge fund managers.